UNIT 6: PROJECT EVALUATION, COST OF CAPITAL AND

INFORMATION MEMORANDUM
Project financing has the followings five stages:
(i) Preliminary feasibility study – At this stage, the following is done:
- Determining the viability of project in terms of finances and technology;
- Analysis of objects;
- Review of the project plan;
- Suggesting alternative ways to achieve objectives.
(ii) Planning – At the second stage, planning covers everything from the initial
consulting and review of the preliminary feasibility study to arranging
financing.
(iii)Arranging finance –This stage involves preparation of the Information
memorandum. An Information memorandum is a selling tool of the project
prepared by the sponsors’ and agent bank to look for potential financers. The
information memorandum:
- fully describes the project and outlines management is plans and policies.
- should be prepared with extensive help of financial advisers.
- should appear to lenders i.e. show that the project can general profits and
social effect.
- assumptions underlying the project should be realistic project should not
over sell.
The information memorandum is like a business plan or even prospectus for the
initial public offer (IPO).
(iv) Monitoring and administering the financing – This stage can be further
broken down into two:
Construction
On this stage, stakeholders:
- Ensure that construction is kept on schedule and that financers are not caught
unaware.
- Prepare estimates to completion, from time to time.
start up
On this stage, actions performed include:
- Monitoring actual operation costs and economics of production against the
financial and production plans.
- Tracking any unexpected occurrences.
(v)Operations – this stage involves:
- Continuation of monitoring operations, cash flows, ratios etc.
- Cash flow analysis and calculate when project should start repaying.
- Selection of external advisors for financial and technical purposes.
Candidates for external advisers include:
1. Commercial banks – for information memorandum formulation
2. Merchant banks - for information memorandum formulation
3. Mayor contractors – when it comes to construction.
4. Legal advisors – for giving legal advice on project’s operation.
5. Auditors – for auditing expenditures.
6. Insurance consultants.
Once the external adviser has been selected an engagement letter is written to
spell out work, fees, timetable rights, people engaged to reduce
misunderstandings.
Contents of information memorandum
The typical information memorandum includes:
■ Disclaimer It is important that it be clearly and prominently displayed.
■ Authority letter Here the borrower authorizes release of the information
memorandum to the syndicate.
■ Project overview A brief description of the proposed project is included first
in the memorandum. The overview includes the type of project, background on
the host country, the status of development and other significant information.
■ Borrower The description of the borrower explains the form of organization
(corporation, partnership, limited liability company) and place of organization
of the borrower. It includes the ownership structure of the borrower.
■ Project sponsors The identity, role and involvement of the project sponsors
in the project is included. Summary financial information about the sponsors is
also given. This section also specifies the management structure of the project
company.
■ Debt amount/uses of proceeds How much debt the project will need is
described generally in this section. Also included is the currency in which the
loan is to be made and repaid. The manner in which loan proceeds will be used
is an important part of the memorandum.
■ Sources of debt and equity The total construction budget and working
capital needs of the project, including start-up pre-operation costs, are outlined
in this section. Also, the sources of the funds needed for the project are
explained, including debt and equity.
■ Collateral This discussion includes the identity of collateral, whether the
collateral is junior in lien priority to other debt, and any special collateral
considerations.
■ Equity terms The terms of the equity are more completely described in this
section. Included are explanations of the type of equity investments; when the
equity will be contributed; how the equity will be funded, whether the
commitment is absolute or subject to conditions, and if conditional, why it is
conditional.
■ Cost overruns The offering memorandum may set forth an explanation of
how any cost overruns will be funded.
■Sponsor guarantee/credit enhancement Any other guarantees or credit
enhancement that the project sponsors will provide are also described.
■ Debt amortization This section describes the proposed debt repayment
terms, including amortization schedules and dates for repayment of interest and
principal. Mechanical elements such as minimum amounts of prepayments,
advance notice of prepayments, may also be described (but are governed by the
loan agreement).
■ Commitment, drawdown and cancellation of commitment The mechanical
provisions are typically included, although they are generally identical
boilerplate clauses in standard loan contracts. These include minimum
drawdown amounts, and timing and notice of drawdowns.
■ Interest rate Typical interest rate options include a bank’s prime (or
reference) rate, being the rate typically offered to its best customers, LIBOR
(London Interbank Offered Rate), Cayman (rates of banks with respect to
Cayman Island branches), and HIBOR (Hong Kong Interbank Offered Rate).
Rates can, of course, also be fixed.
■ Fees The fees offered to the lenders, including structuring fees, closing fees,
underwriting fees and commitment fees, are described. Amounts are usually left
blank and resolved during negotiations.
■ Governing law In this section the choice of law to govern the loan documents
is listed. It is sometimes the law of the host country. However, that is not so in
financings in developing countries, unless lenders in the host country provide all
debt.
■ Lawyers, advisers and consultants This section will identify the lawyers,
advisers and consultants involved in the project; often a budget for legal fees is
requested.

Project evaluation is a process of analyzing the profitability of a project with the

aim of making a decision of whether to undertake it or not. Project evaluation
involves the following:
1. Estimating after tax – incremental operating cash flows i.e. finding the
present value of operating cash flows.
 OC F 1 OC F n
PV = 1
+ …+ n
(1+i) (1+i)
2. Calculating the main evaluation ratios.
The following are the five evaluation ratios that are used for choosing projects;
(i) Accounting rate of return (ARR)
ARR is the average rate of return of a project. It is calculate by dividing average
profit of the project by its average investment as shown below.
Average profit
ARR=
Average investment
The accounting rate of return ratio shows that 1 unit of investment brings x units
of profits. If ARR is greater than minimum accepted rate, then the project is
selected. The main disadvantage of the ratio is that it does not consider time
value of money.
(ii) The payback period method (PBP)
The payback period of a project is the number of years it takes before the
cumulative forecasted cash flow equals the initial outlay. The payback rule only
accepts projects that «payback» in the desired time frame. This method is
flawed, primarily because it ignores later year cash flows and present value of
future cash flows. The latter problem can be solved by using a payback rule
based on discounted cash flows.

(iii) The internal rate of return (IRR)

Defined as the rate of return which makes NPV=0. We find IRR for an
investment project lasting T years by solving:
C1 C2 CT
NPV =C 0+ + 2
+…+ =0
1+ IRR (1+ IRR ) ( 1+ IRR )T
The IRR investment rule accepts projects if the project's IRR exceeds the
opportunity cost of capital, i.e. when IRR>r.
Finding a project's IRR by solving for NPV equal to zero can be done using a
financial calculator, spreadsheet or trial and error calculation by hand.
(iv) The net present value (NPV)
Net present value is the difference between a project's value and its costs. The
net present value investment rule states that firms should only invest in projects
with positive net present value.
When calculating the net present value of a project the appropriate discount rate
is the opportunity cost of capital, which is the rate of return demanded by
investors for an equally risky project. Thus, the net present value rule
recognizes the time value of money principle.
To find the net present value of a project involves several steps:
1. Forecast cash flows.
2. Determinate the appropriate opportunity cost of capital, which takes into
account the principle of time value of money and the risk-return trade-off.
3. Use the discounted cash flow formula and the opportunity cost of capital to
calculate the present value of the future cash flows.
4. Find the net present value by taking the difference between the present value
of future cash flows and the project's costs.
Most projects require an initial investment. Net present value is the difference
between the present value of future cash flows and the initial investment, C0,
required to undertake the project:
n
Ci
NPV =C 0+ ∑
i=1 ( 1+r )i
Note that if C0 is an initial investment, then C0 < 0.
(v) The profitability index (PI)
The profitability index is the ratio of present value net cash flows to the initial
outflow. It is also called benefit – cost ratio.
PV of future cash flows
PI =
Initial investment
The project is accepted if PI≥1
The Project’s cost of capital
The cost of capital is the minimum rate of return an investment project must
generate in order to pay its financing costs. (I.e. paying for principal + interest
on debt finance and dividends on equity issued).
For a leveraged project, the financing costs can be represented by the weighted
average cost of capita WACC.
WACC is a calculation of a project's cost of capital in each category
proportionately weighed i.e. cost of all capital sources.
K= ( 1−⋋ ) K i + ⋋ (1−τ )i

Where, K – WACC
Ki – Cost of equity capital (CAPM)
i – Pretax cost of debt (interest on debt)
⋋ - Debt to total market value ratio
τ – Tax rate

Cost of equity
The cost of equity capital (Ki ) of a firm is the expected return on the firm's
stock that investors require. The return is frequently estimated using the capital
asset pricing model CAPM.
Ṙi=R f + β i (Ṙm −Rf )
Where,
cov (Ri , Rm )
β i=
var (R m )

Where, β i - beta is a measure of systematic risk inherit in security i.

R f - is the risk-free rate of return.

Ṙm - is the expected return on the market portfolio.

cov (R i , Rm ) - is the covariance of future returns between security iand the market

portfolio (RM).
var (Rm ) - is the variance of return of the market portfolio.
THE PROJECT’S BORROWING CAPACITY AND ITS
ABILITY TO SERVICE DEBT
A project’s borrowing capacity is a term used to refer to how much money a
bank can lend to the project given a certain amount of cash flows. There are two
hypotheses regarding the project's borrowing capacity:
Hypothesis A: - Full drawdown of capital in the moment of full completion.
Under this hypothesis, the amount the bank will lend to a project entity should
equal a fraction of the present value PV of the available cash flows.
α × D=PV
Where, α - is the largest cash flow coverage ratio (The cash flow ratio indicates
the ability to make interest and principal payments as they become
due).
D – the maximum loan amount.
PV – present value of future cash flows.
Example:
Given PV of cash flows as 1,488,691 Euro and cash flow cover ratio of 1.5, find
the amount of money a bank should lend to a project entity.
α × D=PV

1.5 × D=1,488,691

1,488,691
D= =992,461 Euros
1.5

Meaning the debt capacity of the project is 992,461 Euro based on an estimated
cash flow of 1,488,691 Euros.

Hypothesis B –the revenues and operating expenses do not begin for M years.

-Under this hypothesis, the amount the bank will lend to a project entity should
equal a fraction of the present value of available cash flows beginning with the
year M.
M

Construction phase Operating phase

Drawing moment for the debt D

The project company will draw the loan in the initial moment but the cash
revenues and expenses are generated the future at time M. The present value of
the project future cash flows should equal present value of debt D drawn in the
initial moment.
M
α × D× ( 1+i ) =PV
Note that M is the estimated period before the project produces any operating
cash flows.
Project’s ability to service debt
The project’s ability to service debt is an analysis of how much money a project
has to service its debt (i.e. principal payments plus interest payments). To
evaluate the project's ability to service its debt, three financial ratios are
normally used:
(i) Interest coverage ratio
This is the ratio used to determine how easily a project company can pay
interest on outstanding debt. The interest coverage ratio is calculated by
dividing a company's earnings before interest and taxes (EBIT) of one period by
the company's interest expenses of the same period.
EBIT
Interest coverage ratio=
Interest expense
The lower the ratio, the more the company is burdened by debt expense. When a
company's interest coverage ratio is 1.5 or lower, its ability to meet expenses
may be questionable. An interest cover ratio below 1 indicates that the company
is not generating enough revenues to satisfy interest expenses.
(ii) Fixed charge coverage ratio
This is the ratio that indicates a project’s ability to satisfy fixed financing
expenses such as interest and leases. It is calculated as follows:
EBIT +¿ charge (before tax)
FCCR=
¿ charge ( before tax ) +interest

EBIT + Lease expenses

For example, FCCRforlease= Lease expenses+ Interest

(iii) Debt service coverage ratio

This is the ratio that shows how much cash is available for debt servicing to
interest, principal and lease payments.
EBITDA+ Rentals
DSCR=
Principal repayments
Interest + Rentals+
1−Tax rate
EBITDA – earnings before interest and tax, depreciation and amortization.
The bigger the figure the better or the more there is cash available for debt
servicing. A DSCR of less than one would mean negative cash flow. A DSCR
of 0.95 would mean that there is only enough operating income to cover 95% of
annual debt repayments.

FINANCIAL MODELING OF A PROJECT

Financial modeling is the task of building an abstract representation (a model)
of a financial decision making situation. It is creating a complete
program/structure which helps you in coming to a decision regarding
investment in a project. Financial modeling Financial modeling of a project
(mostly excel is used for financial modeling) is close to cash flow forecasting.
Financial modeling inputs are measures that are used in modeling a financing
plan. The results of calculations based on inputs are what are called financial
modeling outputs.
Financial modeling inputs include:
- Macroeconomic assumptions.
- Project costs and funding structure.
- Operating revenues and costs.
- Loan drawings and debt service.
- Taxation and accounting.
Financial modeling outputs include:
- Construction phase costs.
- Drawdown of equity.
- Drawdown repayment of debt.
- Interest calculations.
- Operation revenues and costs.
- Tax.
- Income statement.
- Balance sheet.
- Cash flow statement.
- Lender's coverage radio.
Main steps of financial modeling
The following are the main steps in financial modeling:
- Macroeconomic assumption.
- Project costs and funding structure.
- Calculating operating revenues and costs.
- Analyzing the Borrowing capacity of a project.
- Capacity to cover debt service.
- Taxation and accounting.
- Calculating WACC.
- Calculating IRR and NPV for the project.
We further look in detail each of the steps.
Step 1 -Macroeconomic assumption
Targets:
Step 1.1.Inflation (Inflation analysis)
This step includes the offering of a real basis for the project. The following
indications are used in the analysis:
- Consumer price inflation in the host country;
- Indices of unemployment costs in the country of suppliers or providers of
services;
- Industrial price inflation for the cost of spare parts;
- Specific price indices for commodities or purchased by the project.
Step 1.2 Commodity prices
This step refers not to inflation but to the vulnerability of the project to cyclical
movements in commodity prices.
Step 1.3 Interest rates
- Interest rates factors;
- Interest rates components;
- Nominal interest rate vs. real interest rate.
Step 1.4 Exchange rates
The approaches for forecasting exchange rates include:
- Traditional theory;
- Purchasing Power Parity Theory;
- Monetary approach.
Step 1.5 GDP growth
GDP growth will give forecast on the performance of the host country's
economy.
Step 2 -Project costs and funding
1. Project costs:
- Development costs: staff and other travel costs to develop the project.
- Development fees: taxes paid for the location, concessions.
- Project company costs:
 Personnel costs
  Office and equipment
 Costs for permits and licenses
 Construction supervision
 Trainning and mobilisation costs.
- Construction price
- Constraction insurance
- Start up costs include:
 Fuel and raw materials
- Initial spare parts
- Working capital coverage (Note that current assets– liabilities = working
capital):
 Initial inventories;
 Office and personnel costs;
 The first operating insurance premium.
- Taxes: VAT or other sales taxes:
- Financing costs:
 Loan arrangements and underwriting fees;
 Loan and security registration costs;
 Coasts of lender's advisers;
 Interest during construction;
 Commitment fees;
 Loan agency costs.
- Funding of reserve accounts.
- Contingency (provision for unexpected events).
Step 3 -Operating revenues and costs (calculations of):
- Operating revenues from sales of product;
- Operating costs:
 Cost of fuel or raw materials.
  Personnel and office costs.
 Maintainance costs.
 Insurance costs.
Step 4 - Accounting and taxation issues:
- Capitalization and depreciation of project costs;
- Dividend policy;
- Tax payments and accountings.
Step 5 - Project funding:
Here analysis is done on:
- The required ratio between equity and debt;
- The borrowing capacity of the project;
- The capacity of the project to service the debt;
- For each financial source there should be made an amortization table
including:
 Payment of principals;
 Interest payments;
 Annuities.
- The priority of drawing between equity and debt;
- Any limitation of the use of debt;
- A drawdown schedule for both equity and debt;
- WACC analysis.
PROJECT CASH FLOWS
What are cash flows?
Cash flow represents the money coming in or money going out of the
investment project. Money going out of the project represents cash outflow
while money going in the project represents cash inflow. The difference
between money going in and out of the project represents a project net cash
flow.
Sources and uses of cash in a project
The sources and uses of cash in a project are shown in figure 20.1 below.

Sales of assets

Operations Sale of fixed Refinancing

assets
Decrease in working Increase in
capital debt
Sources of cash

Increase in
equily
New profit
Pool of cash

Uses of cash

Net loss from Redemption of

operations equity

Increase in Purchace
working of fixed Repayment
capital assets of debt

From the diagram we can say that the total net cash flow is the sum of cash
flows in three areas:
1. Operation cash flows – cash received or spent as a result of a project's
business activities it includes cash earnings plus changes to working capital.
2.Investment cash flows – cash received from the sale of long term assets or
spent on capital expenditure (sale and purchase of assets).
3. Financial cash flows – cash received from the issue of equity or debt or paid
out as dividends, loan + interest.
Reasons for cash flow analysis (forecast)
1. Coming up with estimates on cash flows, projects loss and the balance sheet
along with a series of ratios based on the same forecasts is vital for valuing the
ability of the project to generate enough cash to cover the debt service and pay
its sponsor dividends that are in line with expected returns.
2. It is also important if the project company wants to bid on a public
concession or BOT scheme.
Factors to consider when calculating cash flows
The following factors should be considered when calculating cash flows:
(i) Timing of the investment
The length of the plant construction period impacts financial costs,
especially interest and commitment fees so it is important to state the
start and end date of project.
(ii) Initial investment costs
Initial costs are normally specified in the construction contract. Initial
costs should also include cost of purchasing the land, owner's costs,
and development costs.
(iii) VAT
During construction, the project company will incur investment costs
subject to VAT (VAT on raw materials acquired from suppliers).
Since the company is not yet operational from a commercial stand
point, it cannot issue invoices and consequently collect VAT regards.
Legislation of various countries allow for different options of VAT
refund like:
 A sponsor who is in a position of debt toward the VAT office can offset
the VAT credit on its return. The sponsor should have 51% or more
shareholding of SPV.
 When SPV starts project operation on a commercial basis, the SPV can
request immediate reimbursement for the VAT credit offering a suitable
guarantee.
 Offsetting the SPV's VAT credits with VAT debts during the operating
phase.
(iv) Public grants (in PPP initiatives)
Public grants represent a key source of financing for building and
operating facilities that serve the needs of the public. Terms on which
governments pay grants include:
 Testing grant – when grant is paid out at the end of the construction
period, provisions are made for bridge financing. Bridge financing is a
method of financing used to maintain liquidity white wailing for an
anticipated and reasonably expected inflow of cash.
 Milestone grant – funds received on the basis of the milestone achieved.
(v) Analysis of the sales contract, the supply contract and operating
expenses
Under analysis of contracts, if contracts are not yet definitive, standard
prices and conditions applied by the market are included in the
calculations. If contracts are definitive, then of take and put or pay
contracts will become the basis of what the inflows or outflows will
be.
(vi) Trends in working capital
Factors to consider will include for example the average collection
period and the average payment model. Delays in these factors have
the effect of differentiating economic margins. Variations in working
capital depending on the sign represent an outlay or source of cash. In
most project finance initiatives weight of investment in working
capital is insignificant e.g. in public transportation where accounts
receivables are virtually non-existent.
(vii) Taxes
All the taxes associated with the project should be considered and a
project manager should always look for ways of reducing the fiscal
burden.
(viii) Macroeconomic variables
All forecasts developed by reputable research agencies e.g. expected
brands in the Interest rate, inflation rate, GDP, etc. should be included
in cash flow forecasts. Also vital is the defining of correlation among
variables like the price and demand of project goods.